Public Bank is among one of the biggest success stories in Bursa Malaysia

Summary

A shareholder who had bought 1,000 Public Bank shares in 1967 (the year it was listed) and held on to them, would be holding 148,938 shares as at end-2016 valued at RM2.94mil. In 

addition, that shareholder would have received a total gross dividends of RM1.2mil.

Trading at 2.3 times book value, Public Bank is easily the most expensive financial institution in the region with rivals commanding valuations of between 0.4 times and 1.4 times.

Its return on equity at 15.6% stands above the industry average of 11.6%, while its return on assets is 1.4%.

The announcement of Teh’s departure some 17 months ahead of the real schedule underlines the strategy of the banking group in putting in place a succession plan and making it public.

Public Bank is the country’s second-most valuable bank and third largest in terms of assets known for its conservative business approach.

So far, Public Bank has earned itself the track record of being among one of the biggest success stories on the local stock exchange.

Saturday, 5 August 2017

Public Bank game changer

BY GURMEET KAUR

The expected retirement of Teh could herald a new beginning for the bank

THERE are several items which are a fixture in Public Bank Bhd.

For instance, try walking into any Public Bank branch and you will find the familiar photograph of Tan Sri Teh Hong Piow, the 87-year-old founder, framed on the wall of the banking hall.

Another fixture is the number of millionaires that the banking group has created. Every year, a segment of the annual report will be dedicated to the number of shares an early investor of Public Bank would be holding now.

In the latest annual report, it was illustrated that a shareholder who had bought 1,000 Public Bank shares in 1967 (the year it was listed) and held on to them, would be holding 148,938 shares as at end-2016 valued at RM2.94mil.

In addition, that shareholder would have received a total gross dividends of RM1.2mil.

That is the winning tagline that has endeared the bank and its founder to both shareholders and staff.

Teh is no ordinary head of a financial institution. He is the face of Public Bank and is credited with building the bank to what it is now. The bank’s asset size and branch network belies the value the market attaches to it.

Trading at 2.3 times book value, Public Bank is easily the most expensive financial institution in the region with rivals commanding valuations of between 0.4 times and 1.4 times.

The valuation is largely due to the returns that the bank has given to shareholders consistently.

Its return on equity at 15.6% stands above the industry average of 11.6%, while its return on assets is 1.4%.

When Teh announced last week that he would be taking a backseat in January 2019, it hardly created any ripples because his departure has been speculated about in the last three years.

The tycoon will retire as chairman come that year, but will not be totally out of the picture.

He will remain as the bank’s adviser and assume the title of “chairman emeritus” in recognition of his contributions to the bank he founded at the age of 35 in 1965.

The announcement of Teh’s departure some 17 months ahead of the real schedule underlines the strategy of the banking group in putting in place a succession plan and making it public.

Overhang due to Teh’s shareholding

Despite the group’s constant assurance of a smooth transition should Teh leave one day, a Public Bank without the patriarch is a scenario that nobody can dare predict with certainty.

It is only to be expected.

None of Teh’s children are with the bank. And his 24% stake, valued at RM19.24bil, makes it an elusive takeover target.

Based on Public Bank’s expensive valuation, it is hard to find a buyer for his block of shares.

It is not only the valuation that would limit buyers.

Any party wanting to buy that block would need Bank Negara’s approval.

So, there are limited buyers.

Under banking regulations, individuals are not allowed to own more than a 5% stake each in a financial institution and in the event it happens, they are to get approval from the central bank.

In the case that happens, they are required to get approval from the central bank.

Currently, there is an unwritten “grandfather rule” that applies to Teh and two others bankers, namely, Tan Sri Azman Hashim of AMMB Holdings Bhd and Tan Sri Quek Leng Chan of Hong Leong Financial Group Bhd.

These individuals are allowed to hold their current stakes in a bank, as their personal stakes in the respective banks were acquired before the Banking and Financial Institution Act 1989 or Bafia – the Financial Services Act 2013’s predecessor – was implemented in 1989.

Azman’s AMMB is currently in merger talks with RHB Bank Bhd and if he stays as a shareholder in the enlarged group, his stake would be diluted to less than 6% from 13% now.

If that’s the case, it would leave Teh and Quek as the first-generation bankers with more than 5% in their respective financial institutions.

According to banking sources, the question of Teh putting his block of shares in a trust is also remote because any movement of more than 5% would need Bank Negara’s approval.

Banks are different compared with other large companies where their substantial shareholders can put their wealth in a trust.

“Banking is a highly regulated industry and any movement of shares of 5% would need regulatory approval,” says a corporate lawyer.

He says the “grandfather rule” exemption would likely stop with these founder bankers and cannot be passed on to their children.

Going forward, institutionalising banks’ shareholding is inevitable. And it applies more in the case of Public Bank because of the concentration in the shareholding with Teh.

Till now, the octogenarian has shown no inclination to part with his block of shares, and the prerogative to do so is entirely his.

One way to go around this, say some, is to break up the block to less than 5% each as what happened in Alliance Financial Group Bhd (AFG) last year.

In that case, Langkah Bahagia Sdn Bhd’s effective 14.8% interest in AFG’s, held through Vertical Theme Sdn Bhd (AFG’s single largest shareholder), was sold to three individuals. Essentially, the emergence of these individuals as owners of the 14.8% stake in AFG circumvented Bank Negara’s ruling and allowed the deal to be done without the regulator’s approval.

Besides Public Bank, Teh also controls about 44% in insurer LPI Capital Bhd where he is chairman.

Business as usual for now

Monday’s announcement hardly ruffled investor sentiment, albeit for a knee-jerk 26-sen fall in share price. Its shares have since rebounded to close at an all-time high of RM20.76 yesterday, giving it a market capitalisation of RM80.16bil.

For now, it appears to be business as usual for the country’s second-most valuable bank and third largest in terms of assets known for its conservative business approach.

Strong and stable: Earnings-wise, the bank can boast of over five decades of unbroken profitability, even during the height of the 1997/98 Asian Financial Crisis that saw many companies going belly up.

While Teh is a central figure where Public Bank is concerned, the running of the bank has been left largely to professional managers, led by the banker’s most trusted lieutenant, Tan Sri Tay Ah Lek, who has been managing director and chief executive officer (CEO) since 2002.

“You can say the bank is on auto-pilot mode ... it has the process in place with the day-to-day undertakings residing in the hands of professional managers,” quips a banking executive.

Still, there is a perception that there appears to be too much dependence on the old guards.

Also, is Public Bank changing the way it runs to cope with future challenges in the financial sector? With the growing challenges in the banking landscape due to disruptive technology, will it be able to move fast enough?

So far, Public Bank has earned itself the track record of being among one of the biggest success stories on the local stock exchange.

The numbers speak for themselves.

Public Bank’s strong franchise among the smaller businesses with its network of branches has allowed it to capture a large size of the retail and small and medium-sized loan market segment that accounted for a large portion of its total loans as at financial year 2016 (FY16).

Earnings-wise, the bank can boast of over five decades of unbroken profitability, even during the height of the 1997/98 Asian Financial Crisis that saw many companies going belly up.

For FY16 ended Dec 31, it made a record RM5.2bil in net profit, while in the first half of FY17, net profits already rolled in at RM2.58bil.

The bank’s stability in asset quality is a major appeal, not forgetting the attractive dividend payouts it dishes out.

Its cost-to-income ratio – a measure of how efficiently a bank is run – at 32.3% is amongst the lowest as opposed to its peers.

While shareholders of the bank have nothing to complain about, Public Bank is seen as lagging behind in facing the future challenges of the financial landscape.

New players are coming in and operating at a cheaper cost compared to traditional banks.

For the longest time, the financial sector was seen as being insulated from disruptive technologies.However, fintech service providers such as Peer-2-Peer operators are ready to take away market share from banks.

“Is Public Bank ready for the challenging banking landscape post the Teh era?” asks a banker.

“It is very much reliant on the traditional lending business. It does not have much wholesale and corporate loans.

“The rates it gives for deposits are not competitive. When corporates look at financial institutions to place their deposits, Public Bank is not usually on their list,” says the banker.

Seasoned team of bankers

While the banking group has some young faces in its management team, some reckon that there is still a big gap in terms of getting new blood in the top echelon.

Based on the group’s information on its website, the average age of its board members is 72.

Its oldest board member is Teh himself, followed by the bank’s deputy chairman Datuk Seri Lee Kong Lam, who is 75.

Tay, meanwhile, is 74 years old, followed by directors Lai Wan, 73, and Tang Wing Chew, 72.

The directors below the age of 70 are its female representatives, namely Lai Wai Keen and Cheah Kim Ling.

Bankers say the most obvious successor to the chairman’s role is Tay.

Having been a pioneer staff of the group, Tay is in tune with Teh’s vision, they say. The bank’s deputy CEO is Datuk Chang Kat Kiam.

Recall that 62-year-old Chang was appointed as deputy CEO early last year, following the departure of accountant Quah Poh Keat.

Quah was seen as a successor to Tay but opted for early retirement in January 2016 three years after his appointment as deputy CEO.

Chang is seen as one of the bankers in the mould of Teh and Tay. A seasoned banker, he has been with the banking group since 1975.

Beyond Chang, the line of succession in Public Bank is not so visible.

New and young blood could provide the impetus to take the bank to the next level, reckon some.

Whatever the case, a scenario without Teh in Public Bank will certainly be a game changer for the bank.

Read more at http://www.thestar.com.my/business/business-news/2017/08/05/public-bank-game-changer/#L0mQIqzUDOdT0W2r.99

Public Bank Berhad

Saturday, 5 August 2017

From conservative to fastest growing bank

BY JAGDEV SINGH SIDHU

THEIR story is one that is long and rich in history. Chinese entrepreneurs have been instrumental in setting up the foundation of the banking industry in Malaysia, which has blossomed during the boom times and withstood many recessions.

With a steady pace of growth and a unique style of doing business, which is said to lean on conservatism, Chinese banks grew at a steady pace that saw them snare a chunk of the Malaysian financial market. The going was good until the Asian Financial Crisis.

Steeped in lending to small and medium enterprises, the number of Chinese-owned banks shrank after the crisis during the consolidation of the banking system by the government.

There was an unwritten policy that there should be two Chinese-owned banks in Malaysia, and the structure of the consolidation kept to that thinking. Public Bank Bhd and Hong Leong Bank Bhd (HLB), which is the metamorphosis of the oldest bank in Malaysia, are the two that have survived till today. Helmed by Tan Sri Teh Hong Piow and Tan Sri Quek Leng Chan, respectively, Public Bank and HLB were consolidated with other Chinese-owned banks. Public Bank was paired with Hock Hua Bank Bhd, while HLB merged with Wah Tat Bank Bhd. Malayan Banking Bhd (Maybank), meanwhile, swallowed Pacific Bank Bhd and PhileoAllied Bank (M) Bhd.

While not all Chinese banks were run at the same level of efficiency prior and during the Asian Financial Crisis, those that did exemplify a level of prudence stood the best chance of gaining market share during such a tumultuous time.

And that bank was Public Bank. Prior to the Asian Financial Crisis, Public Bank was a conservative bank. While others fed the appetite for credit by stretching their balance sheets in search of profit, Public Bank took a very conservative stance.

“Its loan-to-deposit ratio before 1998 was at around 60%, which was very low at that time,” recalls a banking analyst. That unadventurous approach saw the bank’s shares almost plateau at a low, which long-time market watchers say hovered between RM2 and RM3 a share when others were soaring.

But when the crisis struck, Public Bank was the one bank that had the ability and means to lend when everyone was clamping up while trying to stave off a flood of bad loans that were threatening the survival of a number of banks.

It was during that time, and some might say after a tongue-lashing by the Prime Minister back then, that Public Bank laid the foundations for the bank it is today.

It started to lend aggressively and saw huge growth in loans in the ensuing years after the Asian Financial Crisis. From a conservative bank, Public Bank became the country’s fast-growing bank for years after the crisis.

From a loan base of RM19.7bil in 1998, it grew to RM66.8bil by 2005. Its return on equity in that year too crossed 20% after being in the mid-teen levels before. By last year, its gross loans had hit RM294bil.

A huge loan growth kept non-performing loans in check and profits soaring. Public Bank’s big advantage in cheap saving and current account deposits offered it the ability to price its loans competitively.

Furthermore, it was its link to local industries and businesses that helped it to not only snare new customers, but also reap the rewards of an organisational structure that no other bank has managed to replicate.

While most of the modern institutionalised banks today have centralised back-room operations, Public Bank’s method of relying on branch managers to drive its business is unique.

“It has a simplified and clearly defined goals and reward system,” says an analyst on how Public Bank manages to run its business through its branch network.

While some might say that has been the way of Public Bank, others might point to the fact that Public Bank is not just a Chinese-run bank but an owner-run bank.

“In some ways, the business has been institutionalised, but he (Teh) has been instrumental in setting the tone,” he says.

But some of the risks associated with Public Bank are that its exco board is old, with an average age of more than 70, and its IT infrastructure could do with an expensive upgrade.

The allure of Chinese-owned banks for banking groups in Malaysia is the valuable franchise that they have. Should Public Bank or even HLB end up for sale or a merger, the chance is that many would look at them seriously. The one problem is that it will be expensive, as Public Bank’s price-to-book ratio is 2.3 times, while Maybank, the country’s largest bank, is trading at 1.4 times.

CIMB Group Holdings Bhd chairman Datuk Seri Nazir Razak did say that one of the reasons the group wanted to acquire Southern Bank Bhd, another of the Chinese-run banks that survived the consolidation phase, was for its Chinese customers.

He praises the way Public Bank is managed.

“Public Bank has had a fantastic track record through all sorts of operating conditions built on its organisation culture, which enabled a high degree of quick and decentralised decision-making for small businesses that most institutionalised banks found hard to challenge,” he says.

“It is amazing that it could do it at its scale, but I am not sure how much more scalable it can be.”

Read more at http://www.thestar.com.my/business/business-news/2017/08/05/from-conservative-to-fastest-growing-bank/#FSIcwL12jU4sD4XC.99

Tenets of the Warren Buffett Way

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http://klse.i3investor.com/blogs/oldschool_jaejun/128904.jsp

The ROCE, ROA and ROE of Petronas Chemical Group in 2016

Petronas Chemical Group 2016


Balance Sheet

                            2016            2015            Average
CA                      11.5b            12.6b
CL                       21.3b           19.2b
TA                       32.8b           31.8b              32.3b


CL                        2.5b            3.1b
LTL                      2.0b            2.1b
TL                        4.5b            5.2b

TEq                     28.3b           26.6b              27.5b

TEq + TL            32.8b           31.8b



Borrowings         2016             2015  
Short term          0.069b          0.074b
Long term          0.137b          0.183b


What is the average Capital employed of Petronas Chemical in 2016?

Capital employed = TEq + LTL + Short Term borrowings

Capital employed in 2016  =  28.3b + 2.0b + 0.069b = 30.369b
Capital employed in 2015  =  26.6b + 2.1b + 0.074b =  28.774b

Average Capital employed = (30.369b + 28.774b)/2  =  29.6b





Income Statement

                             2016

Revenue              13.9b
EBIT                     4.2b
PBT                      4.1b
PAT                       2.9b



What is the ROCE of Petronas Chemical in 2016?

Return on average Capital Employed (ROCE)
= EBIT / average Capital Employed
= 4.2b/29.6b
= 14.2%

What is the Return on Average Asset of Petronas Chemical in 2016?

ROA
= PAT / Average Total Asset
= 2.9b / 33.2b
= 8.7%

What is the Return on Average Equity of Petronas Chemical in 2016?

ROE
= PAT / Average Total Equity
=  2.9b / 27.5b
= 10.5%


What is the EBIT profit margin of Petronas Chemical in 2016?

EBIT profit margin
= EBIT / Revenue
=  4.2b / 13.9b
=  30.2%


What is the Capital Turnover (Revenue Turnover on its Capital Employed) of Petronas Chemical in 2016?

Capital Turnover
= Revenue / Average Capital Employed
= 13.9b / 29.6b
= 47%



DuPont Formula

ROCE = EBIT profit margin x Capital Turnover

Understanding how a company makes its profits. How a company generates its ROCE?

DuPont analysis

Return on Capital Employed or ROCE
= EBIT / Capital Employed
= (EBIT/Sales) x (Sales/Capital Employed)


ROCE is determined by two elements:

1.  What is happening with profit margins.
2.  Sales generated per $1 of money invested (capital turnover)


1.  Profit Margins

Profit margins are determined by many different factors.

The key influences on profit margins are:

Prices

• Higher prices can boost margins.

Costs

• Particularly important is the split between fixed costs (cost that have to be paid regardless of the level of sales, such as rent and most wages) and variable costs (costs which vary with sales, such as raw materials).  
• Companies with a high proportion of fixed costs can see their margins change rapidly in response to small changes in turnover via a process known as operational gearing.

Mix of products

• Some sales are more profitable than others.
• A car dealer will make little profit on selling a new car but will make lots of profit on selling services and spare parts.
• A company can sell more sophisticated products at a higher price for its most profitable sales.

Volume sold

• Selling more products can boost margins where the company has a high proportion of fixed costs (i.e high operational gearing).
• This process can also work in reverse and is clearly seen in manufacturing companies.
• For example, an industrial plant will have costs related to buildings and machinery, energy, raw materials and wages.  
• Most of these costs are fixed and the company needs to sell a large amount of goods to cover them and break even.
• Once past break even, the fixed costs are spread over a larger amount of sales, which allows profits to increase rapidly.
• However, a sharp fall in sales pushes the company back towards break even and possibly into a loss if income cannot cover all the fixed costs.

By analysing these factors allows us to understand the business behind the profit margin numbers.

Profit margins which fluctuate over a period of time are a tell-tale indicator of a cyclical business (where sales move up and down in line with the general economy) and possibly one with high operational gearing.

• These businesses are more risky and their shares do not make suitable LONG TERM investments.
• Stable profit margins are a desirable characteristic of a business for long term investments.

Please spend time reading a company's annual report to see if it has anything to say about profit margins.

• Pay particular attention to any mention of changes in prices, sales mix and volume changes.
• High-quality companies grow by selling more (volume) and not just by charging more.
• A company which increases prices but does not increase sales is showing that its customers are responding to the price rise by buying less from them.
• This maybe a sign of trouble ahead and may lead to stagnating or lower profits in the future.

2.  Capital turnover

Capital turnover looks at how effectively a company is spending its money to produce sales.

A company can increase capital turnover by adopting some of these measures:


Boosting sales

• For example, increasing sales with new products.

Reducing money invested.

• Cutting working capital by holding less stock of finished goods, getting customers to pay their bills faster and paying suppliers later.
• Cutting the amount of money invested in new assets (capital expenditure, or capex), reducing spending on new assets or increasing efficiency by getting more sales for less investment.
• Getting rid of under-performing assets that have low capital turnover and low ROCE.

Additional notes:

How do you work out the capital employed or the amount of money a company has invested?

Capital employed 
= Total Asset - non-interest bearing Current Liabilities

Using the Asset side of the Balance Sheet:

#Capital employed 
= Total asset - Current Liabilities + Short-term borrowings


Using the Liability side of the Balance Sheet:

*Capital employed 
= Total Equity + Long-term Liabilities + Short-term borrowings
= Total Equity + other Long-term Liabilities + Long-term borrowings + Short-term borrowings
= Total Equity + other Long-term Liabilities + Total borrowings



How do you work out the ROCE?

ROCE = return on capital employed

Numerator equals earnings produced for all capital providers = normalised EBIT

Denominator includes debt and equity contributed to the business. This is also the money invested into the business.

ROCE is usually calculated using a company's average capital employed over a period of two years. 

ROCE = ( EBIT / average Capital Employed)   x 100%




---------




The mathematical equations:

Total Asset = Total Liabilities + Total Equity

FA + CA = CL + NCL + Eq

(FA + CA - CL) = (NCL + Eq)

(FA + CA - CL) + STBorrowings = (NCL + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + Other LTLiabilities + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + STBorrowings + Other LTLiabilities + Eq)

#Total assets - CL + STBorrowings = Total Borrowings + Other LTLiabilities + Equity

or

*FA + NWC + STBorrowings = Total Borrowings + Other LTLiabilities + Equity



#Capital employed = Fixed asset + Current Asset - Current Liabilities + Short-term borrowings

*Capital employed = Fixed asset + Net Working Capital + Short-term borrowings

How to find Quality Companies? (Checklist)

Here is a useful checklist you can use when you are searching for quality companies:

1.   Company's sales record.

• You want to see high and growing sales, year after year.
• A ten-year period of increasing sales and profits is a good sign.

2.  Company's profits.

• You want to see high and growing profits, as measured by normalised EBIT, year after year.
• A ten-year period of increasing sales and profits is a good sign.

3. EBIT and normalised EBIT 

• Check that these are roughly the same in most of the last ten years.

4.  EBIT margin.  

• The EBIT margin must be of at least 10% almost every year for the last ten years.

5,  ROCE

• The company must have a ROCE that is consistently above 15% over the last ten years.
• ROCE = (EBIT / average capital employed ) x 100%

6.  DuPont analysis

• Carry out a DuPont analysis to find out what is driving a company's ROCE.
• ROCE = EBIT/Capital Employed = (EBIT/Sales) x (Sales/Capital Employed)
• ROCE = {Profit margin x Capital turnover)

7.  Annual report

• Read a company's annual report to provide context for the numbers.

8.  FCFF and FCF

• Look for a growing free cash flow to the firm (FCFF) and free cash flow for shareholders (FCF), over a period of ten years.
• FCFF and FCF should also be roughly the same in most years.
• That is, little debt.

9.  Operating cash conversion ratio 

• Look for companies that turn all of their operating profits (EBIT) into operating cash flow, as represented by an operating cash conversion ratio of 100% or higher.
• Operating cash conversion ratio = (operating cash flow / operating profit) x 100%
• That is, high quality earnings

10.  Capex ratio

• Look for capex ratio less than 30% almost every year over the last ten years.
• That is, low capex requirements.
• Capex ratio = Capex / Operating Cash Fow

11.  Compare Capex to its depreciation and amortisation expenses.

• If the company is spending more on capex than its depreciation and amortisation expenses, it is a sign that it is spending enough but you need to be sure it isn't spending too much.

12.  FCFF/Capital Employed or CROCI

• Check for free cash flow to firm return on capital invested that is higher than 10% almost every year over the last ten years.
• This is also known as cash-flow return on capital invested (CROCI)
• CROCI = adjusted free cash flow tot he firm (FCFF)/average capitl employed

13.  Compare FCFps to EPS

• Look for free cash flow per share to be close to earnings per share in most of the last ten years.
• That is, high quality earnings.

14.  Free cash flow dividend cover

• Free cash flow per share should be a larger number than dividend per share in most years.
• That is, the free cash flow dividend cover should be greater than 1.
• Free cash flow dividend cover = FCFps / DPS
• Occasional years when this is not the case are fine.

15.  Consistent Growth

• Prefer more consistent growth in turnover and profit to more volatile growth.

Comments:


Don't worry if you cannot find a company that meets ALL of the criteria above.

There are some exceptional companies that do.

Typically you will not find hundreds of them.

Companies can improve and the ones that might not have been good ten years ago can be good companies now.

If you can find companies that have a high and improving ROCE and have been good at converting profits into free cash flow over the last five years, you should consider them as well.

Quality companies turn most of their profits into free cash flow on a regular basis.

The stock market is littered with companies that seemed to be profitable but turned out to be anything but.

By studying how effectively a company converts profits into free cash flow,  you can save yourself a lot of heartache and painful losses.

One of the simplest and best ways to test the quality of a company's profits (high quality earnings) and whether you think they are believable or not is to compare a company's underlying or normalised earnings per share (EPS) with its free cash flow per share (FCFps).

The free cash flow per share will show you how much surplus cash the company has left over to pay shareholders.

It can often be very different from EPS, even though it is supposed to tell you the same thing.

For many years, you want to see that free cash flow per share has been close to EPS.

Checking the Safety of Dividend Payments using Free Cash Flow Dividend Cover

A quick way to check whether cash flow is sufficient to pay dividends is by using the free cash flow dividend cover ratio.

This is calculated as follows:

Free cash flow dividend cover 
=  free cash flow per share / dividend per share

If free cash flow is sufficient to pay dividends then the ratio will be more than 1.

It is a goo idea to compare free cash flow per share with dividends per share over a period of 10 years.



Interpreting free cash flow dividend cover

1.  A great business generates consistent and growing free cash flows.

2.  During a company's period of heavy investment, the free cash flow may not cover its dividend.

3.  Usually, this maybe for that period and its free cash flow will soon be more than sufficient to cover dividends.

4.  When free cash flow per share exceeds the dividend per share by a big margin, it can be a sign that the company may be capable of paying a much bigger dividend in the future.

How to calculate the Free Cash Flow to Firm and Free Cash Flow to Shareholders

There are two definitions of free cash flow, both of which are useful for investors:

1.  Free cash flow to the firm (FCFF)
2.  Free cash flow for shareholders (FCF).

Free cash flow for shareholders is also referred to as free cash flow for equity.

These can be calculated very easily from a company's cash flow statement.


FCFF

To calculate FCFF, take a company's cash flows from operating activities, add dividends received from joint ventures and subtract tax paid to get the net cash flow from operations.  The subtract capex.

Net cash from operations
less Capital expenditure
add Dividends from joint ventures
= FCFF



FCF

To calculate the FCF, take the FCFF number and subtract net interest (interest received less interest paid), any preference share dividends, and dividends to minority shareholders.


FCFF
less dividends paid to minorities
less interest paid
add interest received
=FCF




When FCFF is not much different from FCF

A company with very little debt and thus, a tiny interest payment, virtually all of the free cash flow produced by the business (FCFF) becomes free cash for the shareholders (FCF).

In such a company, there is not much difference between FCFF and FCF.

This is a positive sign for investors and investors should look for this sort of situation in companies they are analysing.


When FCFF is consistently different from FCF

A company with a lot of borrowings has high interest bills to pay.

In this company, the FCFF and FCF can be consistently different for many years.

This is because the interest payments eat up a big chunk of the company's FCFF, leaving less FCF for shareholders.




Avoid companies with lots of debt

In general, it is a good idea to avoid companies with lots of debt.

• Too much of their free cash flow to the firm can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their free cash flows to repay debt and lower their future interest bills.

• This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Additional notes

Free cash flow to the firm (FCFF)

The amount of cash left over to pay lenders and shareholders.

Operating cash flow less tax and capex.


Free cash flow (FCF)

The amount of cash left over after a company has paid all its non-discretionary costs.

It is the amount of cash that the company is free to pay to shareholders in a year.

Operating cash flow less tax and capex, interest paid and preference dividends.

Can quality be more important than price?

"It is better to pay a little too much for something that is a very good business than it is to buy some bargain but really a company without much of a future."  
- Warren Buffett, chairman and CEO of Berkshire Hathaway.


Paying too much for a share can result in disappointing returns.

No company, no matter how good, is a buy at any price.

Share valuation is not an exact science.

Your valuation will never be exactly right.

By setting yourself some limits, you can reduce the risks that come from overpaying for shares.



Paying for a quality business can still pay off in the long run.

There is some evidence to suggest that paying what might seem to be a moderately expensive price (slightly more than the suggested maximum) for a quality business can still pay off in the long run.

The caveat here is that you have to be prepared to own shares for a very long time.  Perhaps, forever.



The way people invest is changing.

Many people are not building a portfolio of shares during their working lives to cash in when they retire.

An increasing number will have a portfolio that may remain invested for the rest of their lives.

• For them a portfolio of high-quality shares of durable companies may help provide them with a comfortable standard of living, with the initial price paid for the shares not being too big a consideration.

Are investors under-valuing the long term value of high quality businesses?

Remember, the shares of high quality businesses are scarce.

This scarcity has a value and might mean that investors undervalue the long term value of them.

The ability of high-quality companies to earn high returns on capital for a long time can create fabulous wealth for their shareholders.

This is essentially how investors have built their fortune (such as Warren Buffett).



Challenge your thinking by answering these questions

1.   Can you list some examples of high-quality companies with high and stable returns on capital that have created substantial wealth over the last decade?

2.   Look at them carefully.  Do you agree that few, if any, of these shares could have been bought for really cheap prices?

3.   In many of these cases, do you concur that the enduring quality and continued growth of the companies could be seen to have been more important than the initial price paid for them?

How to value shares (checklist)

Here is a checklist to remind me of the process when valuing shares:

1.  Value the companies using an estimate of their cash profits.

• What is the cash yield a company is offering at the current share price?
• Is it high enough?

2.  Calculate the company's earnings power value (EPV).

• How much of a company's share price is explained by its current profits?
• How much is dependent on future profits growth? 
• If more than half of the current share price is dependent on future profits growth, do not buy these shares.

3.  What is the maximum price you will pay for a share.

• You should try and buy shares for less than this value.  
• Apply a discount of at least 15%.
• The interest rate applied to calculate the maximum price should be at least 3% more than the rate of inflation.

4.  To pay a price at or beyond the valuations above, you must be confident in the company's ability of continuing future profits growth (quality growth companies).

• The higher the price paid for profits/turnover/growth, the more risk you are taking with your investment.
• If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

Additional notes:

Investing using checklists is a very powerful method.

It focuses your thinking and guides you in the investing process.

If you are to be a successful investor in shares, you need to pay particular attention to the price you for for them.

• The biggest risk you face is paying too much.
• It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high quality and safe company.

• Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

Also, do not be too mean with the price you are prepared to pay for a share.

• Obviously you want to buy a share as cheaply as possible, but you should also realise that you usually have to pay up for quality.
• Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.
• Some shares can take years to become cheap and many never do.

Comparing average capex spending with depreciation and amortization.

1.   Where depreciation and amortization <<< capex

In some cases, the annual depreciation and amortization expense is a lot less than the average five- or  ten-year capex.#

This is the case in asset intensive companies.

When you see this, you have two good reasons against investing in them.  It should not be surprising that these companies

• have very poor free cash flow track records and 
• modest ROCE performances.

Avoid these companies, unless they have been able to produce a good ROCE whilst investing heavily.


2.  Where depreciation and amortization >>> capex.

Normally, you should be suspicious of companies with this kind of behaviour.

Is this a company that has been under-investing?

If yes, this could hurt its ability to make more money in the future.

However, you need to study the company's history on this issue to make sure that it is not under-investing.

Some companies have to spread the cost of things over their useful lives, (for example the costs of a TV channel such as licences, customer contracts, software and programme libraries), which don't need to be matched by outflows of cash every year.   



# As a rough rule of thumb, if the five-year capex figure is higher than the ten-year average, you should use the higher figure.

Charlie Munger's opinion of Benjamin Graham's deep Value Investing

Why Charlie Munger Hates Value Investing

When Charlie Munger ( Trades , Portfolio ) came to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) in the late '60s, Warren Buffett (Trades, Portfolio) was still running the business and investing how his teacher, Benjamin Graham, had taught him to - by buying a selection of cigar butt type companies and holding for many years.

Unlike Buffett, who had essentially grown up under Graham's wing, Munger had no such attachment to the godfather of value investing. Instead, Munger seems actually to dislike deep value investing:

"I don't love Ben Graham and his ideas the way Warren does. You have to understand, to Warren - who discovered him at such a young age and then went to work for him - Ben Graham's insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. 

"I think Ben Graham wasn't nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can't do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals - probably the only intellectual - in the investing business at the time." - Charlie Munger, The Wall Street Journal September 2014

When he arrived at Berkshire, Munger actively tried to push Buffett away from deep value toward quality at a reasonable price, which he did with much success.

All you need to do is to look at Buffett's acquisition of See's Candies in the late 1960s to realize that without Munger's quality over value influence on Buffett, Berkshire wouldn't have become the American corporate giant it is today.



A love of high quality

Munger always had a fascination with buying high-quality businesses, and in the early days, his style differed greatly from that of Buffett. He always placed a premium on the intangible assets of a company, those assets that had no financial value to other companies but were worth billions in the right hands.

"Munger bought cigar butts, did arbitrage, even acquired small businesses. He said to Ed Anderson, 'I just like the great businesses.' He told Anderson to write up companies like Allergan ( AGN ), the contact-lens-solution maker. Anderson misunderstood and wrote a Grahamian report emphasizing the company's balance sheet. Munger dressed him down for it; he wanted to hear about the intangible qualities of Allergan: the strength of its management, the durability of its brand, what it would take for someone else to compete with it. 

" Munger had invested in a Caterpillar ( CAT ) tractor dealership and saw how it gobbled up money, which sat in the yard in the form of slow-selling tractors. Munger wanted to own a business that did not require continual investment and spat out more cash than it consumed. Munger was always asking people, 'What's the best business you've ever heard of?'" - "The Snowball: Warren Buffett and the Business of Life" by Alice Schroeder

Munger understood that it's these businesses where big money is made as the high returns on capital, and a nonexistent need for capital investment ensures shareholders are well rewarded over the long term.

For example, in his 1995 speech, "A Lesson on Elementary, Worldly Wisdom As It Relates to Investment Management & Business," Munger said:

"We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses. 

" Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result. 

" So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects."

Buffett added some meat to this statement at the 2003 Berkshire Hathaway meeting:

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke ( KO ) has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money but can't generate high returns on incremental capital - for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist."

These quotes do a great job of summing up Munger and Buffett's investment strategy. Even though there are thousands of pages of investment commentary from both of these billionaires, their investment style can be summed up with the simple description of quality at a reasonable price, and the above quotes show exactly why they've both decided this style is best.

By: GuruFocus

http://www.nasdaq.com/aspx/stockmarketnewsstoryprint.aspx?storyid=why-charlie-munger-hates-value-investing-cm774232

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either

• do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
• look for another share to buy.

Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.

Do you always avoid all companies with large amounts of debt?

In an ideal world, you will select to invest in companies that produce consistently high returns and have low levels of debt.

This is the essence of quality and safe investing.

Do you always avoid all companies with large amounts of debt?

Not necessarily.



When larger debts are not a problem

There are some companies which can cope with higher levels of debt and still potentially make good investments.

These are companies with very stable and predictable profits and cash flows.

They have consistently high debt to total asset ratio and quite low levels of interest cover, and yet, they have many of the hallmarks of a quality company.

They have

• grown their sales, profits (EBIT) and free cash flows, 
• whilst maintaining high profit margins (EBIT margins) and 
• very good levels of ROCE.

The general point is:  if a company shows it can continue to increase turnover and EBIT - sales and profit - year after year, whilst holding high levels of debt, this can still be regarded as a quality company and potentially a good investment.

Is negative free cash flow always bad?

The best companies to buy are ones that have large and growing amounts of free cash flow.

One possible drawback of this approach:  you will ignore companies with small or even negative free cash flows because they are investing heavily in new assets to grow their future sales, profits and operating cash flows.




Should you ignore companies like this?

Ideally, you will try to find companies that don't need to spend a lot of capex to grow.

However, if you come across what appears to be a quality company that is spending a lot of money, then you need to make sure the company is getting a good return on that investment.

You need to look at the trend in ROCE at the same time as you are looking at free cash flow.

If ROCE is high and rising whilst a company is spending heavily then the company could start generating lots of free cash flow when its spending settles down - if it ever does.

The main issue is how much money the company needs to spend to maintain its assets in a steady state.

The point here is that you might be making a mistake by ignoring companies with low or negative free cash flow.

There could be a great cash flow business waiting to blossom.




Four simple rules

Four simple rules when comparing FCF per share with EPS when looking for possible investment candidates:

1.  FCFps is 80% or more of EPS = definite candidate

2.  FCFps is less than 80% of EPS and ROCE is increasing = possible candidate

3.  FCFps is less than 80% of EPS but ROCE is falling = avoid

4.  FCFps is consistently negative = avoid

The free cash flow per share figure is all-revealing:  you want to see quality companies with a consistently similar EPS and FCFps, not companies where these numbers are markedly different.

Sell the losers and let the winners keep riding

For long term investing success it is important to ride a winner. 

Ever so often, investors make profits by selling their appreciated online stocks, but hold onto stocks that have declined in hopes of a rebound. 

If an investor doesn't know when it's time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. 

Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice.

If you have a personal preference to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. 

No one in the history of investing with a "sell-after-I-have-tripled-my-money" mentality has ever succeeded.

Don't underestimate a stock that is performing well by sticking to some rigid personal rule - if you don't have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and too limiting.

The Basics of Share Valuation

You can only make money from investing in shares of good quality companies if you pay the right price for the shares.

A common mistake by investors is to think that buying quality companies is all that matters and the price paid for the shares is irrelevant.

Paying too high a price for a share is one of the biggest risks that you can take as an investor.

It is just as bad as investing in a poor-quality company in the first place.

The key to successful long-term investing is buying good companies at good prices.



Valuation

The price of a share is crucial to your long-term investing success.

You will need to learn how to value the shares of companies and set target prices for buying and selling them.

The valuation of shares can become a very complicated exercise.

There are lots of books out there on this subject and many make the process seem difficult to understand.

The good news is that it doesn't have to be this way.

Valuing shares is not a precise science: you only need to be roughly right and err on the side of caution.

The place to start is looking at the fair value of a share.



The fair value of a share

Professional analysts and investors spend lots of time trying to work out how much a share of a company is really worth.

To do this they need to estimate how much free cash flow the company will produce for its shareholders for the rest of its life and put a value on that in today's money, which is known as a present value.

This approach is known as a discounted cash flow (DCF) valuation.

There are three steps to doing a DCF valuation:

1.  Estimate free cash flow per share for a period of future years.
Most analysts would probably try to forecast 10 years of future free cash flows.

2.  Choose what interest rate you want to receive in order to invest in the shares.
Shares are risky investments - more risky than savings accounts and most bonds - and so people demand to receive a higher interest rate in order to invest in them.

3.  Estimate what the value of the shares might be in 10 years' time and give that a value in today's money.
This is the terminal value and it stops you having to estimate free cash flows forever.  

Measuring a company's debt

There are lots of ratios which can be used to explain a company's debt position.

For most investors the following four will tell what they need to know:

1. Debt to free cash flow.
2. Debt to net operating cash flow.
3. Debt to assets.
4. Interest cover.

These ratios only deal with debt shown on a company's balance sheet.

Investors must also be aware and be able to deal with hidden, or off-balance sheet, debts too.

1.  Debt to free cash flow

Debt to free cash flow tells you how many years it would take to repay all a company's debt with the current rate of free cash flow it is producing.

The lower the number, the better, as a lower number means that a company can repay its debt quickly.

You should rarely look at a company with a debt to free cash flow ratio that has been consistently more than 10.

Debt to free cash flow is calculated as follows:  

debt to free cash flow = total borrowings / free cash flow

This ratio can give a high number for two reasons:

• high debt or
• low free cash flow.

It will give a negative number if a company has negative free cash flow.

Like all ratios, it is best looked at over a number of years to see if it is normal for a company to have a high value or it it is a recent trend.

Companies with low debt to free cash flow have enough free cash flow to pay off all their borrowings in a matter of months.

Property, pubs and utility companies normally have high levels of debt as they are deemed to have sufficiently stable cash flows to support it.

Example:  

Company X would take 200 years to repay its debts based on its current free cash flows.

Debt to free cash flow = 200.

This is not normal given its recent history.

This would suggest that you need to investigate what is going on.

• Has debt surged?
• Has free cash flow plummeted?
• Does the management have a plan to reduced debt and increase free cash flow?

2.  Debt to net operating cash flow

Net operating cash flow is the amount of cash a company has from trading after it has paid its taxes.

By comparing this number with the total amount of debt, you can see how long it would take the company to pay back the debt if it stopped investing in its assets.

The lower the number, the better.

It is calculated as follows:

debt to net operating cash flow = total borrowings / net operating cash flow

This is the worst-case scenario test.

This ratio assumes the company spends nothing at all on maintaining its assets for a period of time.

This only happen for a couple of years for most companies before their assets become worn out and lose their ability to make money.

Therefore, with most companies, you want to see a debt to net operating cash flow ratio of less than 3.

Value for this ratio of over 5, indicates companies with significant amounts of debt relative to their cash flows.

Companies with poor profits and cash flows have high debt to net operating cash flow and have increased financial risk.

3.  Debt to assets

Debt to assets tells what percentage of a company's assets is taken up by debt.

The higher the percentage, the more risky a company generally is.

It is calculated as follows:

debt to assets = total borrowings / total assets

Generally speaking, avoid companies where the debt to total assets ratio is more than 50%.

This is one of the reasons why shares of banks can be extremely risky, as debt to assets ratios are over 90% in 2016.

Company with a very low percentage of debt to its total assets is a good sign.  

4.  Interest cover

Interest cover is not a measure of debt, but a measure of how many times a company's annual trading profits (EBIT) can pay the interest on its debt.  

The higher the number, the safer the company is.

Interest cover is calculated as follows:

interest cover = EBIT / interest payable

Look for a figure of at least five times, however, prefer to invest in companies where the ratio is 10 or more.

Danger zone is when the interest cover falls to 3 or less.

Excluding utility companies and property companies which have high levels of debt - and therefore low interest cover - a figure of 5 means that profits can fall by at least 40% before the ratio starts getting into the danger zone of interest cover of 3 or less.

Summary:

For most investors the following four will tell what they need to know:

1.  Debt to free cash flow.

Avoid if Ratio > 10

Good if Ratio < 10

Lower the better

2.  Debt to net operating cash flow.

Avoid if Ratio > 5

Good if Ratio < 3

Lower the better

3.  Debt to assets.

Avoid if Ratio > 50%

Good if Ratio < 50%

Lower the better

4.  Interest cover.

Avoid if <3:1 div="">

Good if > 5:1

Higher the better

Using debt ratios to analyse companies

The debt measure ratios for five companies.

Name   Debt to OPCF   Debt/FCF   Interest Cover   Debt/Total Asset
A          7.8                     22.9                 1.8                 162.0%
B           0.2                      0.2             213.9                     6.7%
C           6.5                    47.9                 2.1                   43.3%
D           2.5                      4.1                 6.8                   44.3%
E           6.4                     39.1                 2.5                   58.1%


Company A
This company's debt would take nearly 23 years to pay back.  Debt/FCF = 22.9
Its profits cover its interest payments less than twice.  Interest cover = 1.8x.
This kind of situation represents a risk of going bankrupt if profits were to deteriorate.
This would be enough to put investors off buying its shares.

Company B
This company operates a chain of fast food pizza chain.
It has very low levels of debt on its balance sheet.  Debt/Total Asset = 6.7%.
It could repay all its borrowings in less than three months based on its current free cash flow - Debt/FCF = 0.2.
It has no problems paying the interest on it.  Interest cover is 213.9x.
This is a kind of company investors might want to own shares in.

Company C
This company is in the pub business.
Pub companies are frequently financed with high levels of debt.
These companies can also tend to be quite poor at producing lots of free cash flow, as they have to keep spending money to keep their pubs in good conditions. (Heavy capital expenditure).
This makes them quite risky investments for shareholders when times get tough and profits fall.
These companies are often forced to sell their assets - pubs - to repay debts.

Company E
This is a water company (utility company).
Water companies are financed with lots of debt.  Debt/Total Asset = 58.1%.
This is not usually a problem given that they have very stable and predictable profits and cash flows.
Water is not the kind of product that tends to see demand change if the economy changes.
However, if investors are building a portfolio of quality companies with high free cash flows and ROCE, then it is unlikely that they will own shares of water companies.
This is because the returns they can earn are capped by industry regulators, which means they have very low ROCE.

Company D 
This is a hotel chain company.
Its business is conservatively financed and meets investors' target debt criteria.

How to avoid bad investments?

Picking winning shares is something every investor naturally wants to do.

However, success in investing is just as much about avoiding bad investments and minimising the risks that you take with your money.

Investors spend too much time thinking about how much money they can potentially make from owning a share and not enough time thinking about how much money they could lose if things go wrong.

Avoiding bad investments is important because they are hard to recover from.  If you lose 50% of your money invested, you need to find an investment that will double in value just to get the value of your portfolio back to where it started.

The more bad investment you can avoid, the better your long-term investment performance is likely to be.



How do you stay away from bad investments?


1.   The first thing to do is to focus your investments on quality companies with the following characteristics:

• A consistent track record of increasing sales and profits.
• High returns on capital employed (ROCE).
• An ability to turn a high proportion of profits into free cash flow.

2.  Arguably, the biggest danger that shareholders face when investing in a business is the company's debt.  

The investor must learn how to analyse a company's debts and to distinguish between safe and dangerous companies.  

This will help the investor to stay away from risky investments that have the potential to damage his/her wealth.

Don't use the PE ratio

The price to earnings ratio (PE) s the most commonly used valuation yardstick by investors.

It is very easy to calculate.

PE ratio = share price / earnings per share (EPS)


In simple terms, shares with high PE ratios are seen as being expensive whilst those with low ones are seen as being cheaper.

Despite its simplicity, PE ratio has many pitfalls that can give investors a misleading view of how cheap or expensive some share really are.

The PE ratio's drawbacks are all to do with the "E" or EPS, part of the calculation


1.  EPS is easy to manipulate.

Companies can boost EPS by changing accounting policies.

For example, they can extend the useful lives of fixed assets such as plant and machinery, which lowers the depreciation expense and boosts profits.

2.  EPS says nothing about the quality of profits.

It doesn't take into account whether profits have changed due to sales of existing products or services - the best source of profits growth - or whether the company has invested heavily in new assets or bought another company (acquisition).

Share buybacks boost EPS by shrinking the number of shares outstanding, even if profits are static or shrinking.  Buyback can be done when the shares are expensive.  By paying too much, a large chunk of shareholder value is destroyed; the cash spent is wasted.

3.  EPS may not resemble true cash profits.

Quite often a company's true cash profits are significantly more or less than its EPS (more often less).

4.  EPS may be based on profits that are unsustainably high or temporarily low.

This means that the PE ratio could be misleadingly low or high.  

This is a particular problem for cyclical companies.



Summary:

For the above reasons, EPS can be unreliable and you should not rely on PE alone.

Once again, PE has may pitfalls that can give investors a misleading view of how cheap or expensive some shares really are.